Written by Kreig Mitchell, Attorney at Law
The Covid-19 situation has impacted just about every individual and business in the U.S. The Federal government has implemented a number of stimulus measures. The legislation is several thousand pages long.
While there is a lot written on these topics, very few articles actually provide information that can be used to formulate actionable steps to take advantage the monies and programs that are available.
This article is our attempt to provide a big picture summary for our clients. It is intended to spark conversations about what approach works best given the unique circumstances for each of our clients.
Since cash flow is the immediate need, this article will start with the ways to obtain cash now. The article will then address the various options for loans and monies that may have to be repaid in time.
- Recovery Tax Rebates
- Unemployment Payments
- Employee Retention Tax Credits
- Net Operating Loss Carrybacks
- Paycheck Protection Loans
- Economic Injury Disaster Loans
- Section 139 Payments
- Retirement Distributions & Loans
Recovery Tax Credit Rebates
The recovery tax rebates have been in the news. This is a tax credit that will be reported on the individual income tax returns for 2020.
To qualify, the individual has to have earned at least $2,500 of income in 2020 and incurred a tax liability in excess of the standard deduction. The income that is considered includes earned income, Social Security income, and pension income.
The government is advancing these tax credits to taxpayers now, rather than waiting to see if the taxpayers qualify for the credits. The refund checks cannot be issued after December 31, 2020. The IRS is expected to issue recovery checks in about three weeks.
To determine the amount of the checks to issue, the IRS will use either the taxpayers’s 2019 income tax return, or if the 2019 tax return has not yet been filed, the taxpayer’s 2018 tax return.
The checks will be $1,200 for singles and heads of households ($2,400 for married couples filing joints returns). There is an additional $500 per qualifying child dependent under age 17.
There are phase out rules that limit the amounts to be paid to those who earn more money. The rebates begin to phase out for adjusted gross income in excess of $75,000 single taxpayers, $122,500 for those who claim head of household), and $150,000 for those who file as married filing joint.
While the refunds may be issued in 2020, eligibility is based on the information reported on the taxpayer’s 2020 tax return. If the individual does not earn $2,500 of income or income in excess of the standard deduction, they may find that they received a check they did not qualify for. The IRS will no doubt seek to recoup this overpayment by assessing it as additional tax owed for 2020.
Suffice it to say that employees who were laid off due to Covid-19 should immediately apply for state unemployment benefits.
Because, the Federal government expanded the scope and coverage of these benefits, most contractors and self-employed business owners should also immediately apply for benefits.
The Federal legislation added Pandemic Unemployment Assistance (“PUA”). This legislation provides an additional $600 per week over and above the unemployment assistance provided under state law. It applies to those who are unemployed due to Covid-19. It also covers self-employed workers (including gig workers and independent contractors), part-time workers, and those with limited work histories. While these workers may not qualify for state unemployment, they may qualify for the $600 per week PUA coverage.
Congress added coverage for the first waiting week, which does not qualify for coverage in most states. This is another reason why it is important to file early.
Last, Congress added 13 weeks of Federally-funded unemployment compensation for individuals who have exhausted their state unemployment benefits. This coverage is available immediately and through December 31, 2020.
It is not clear how these rules will be applied. Most advisors are recommending employees, contractors and business owners file for unemployment benefits.
One caveat that has to be considered is whether the amounts will be charged back to the businesses or impact the business’ unemployment rates going forward.
Employee Retention Payroll Credits
This is a refundable payroll tax credit. The term “refundable” means that the IRS is authorized to issue checks in excess of the amount of payroll taxes paid in for the quarter. For some businesses, this may trigger a payroll tax refund check.
To qualify for retention payroll tax credits, the employer has to either (1) have its operations fully or partially suspended due to a government order limiting commerce, etc. or (2) suffered a greater than 50 percent reduction in quarterly receipts, measured on a year-over-year basis (the credits phase out at an 80 percent reduction).
The retention payroll tax credits equal 50 percent of wages paid by employers to certain employees. The amount of the credit is also limited for each employee. The amount of the credit is computed based on the first $10,000 of wages and compensation, including health benefits, paid by the employer to the employee before December 31, 2020.
For employers with more than 100 employees, only amounts paid to employees who are not working due to Covid-19 are counted. For employers with less than 100 employees, amounts paid to all employees are counted.
Except as noted above, these credits are available for all employees. This includes S corporation owners who are paid a salary or wages. It also includes amounts paid for workers who are paid less, but still on payroll.
Businesses should review their payroll reporting process to ensure that they capture these tax credits.
Net Operating Loss Carrybacks
A net operating loss (“NOL”) generally arises when the income from a business or rental activity is less than the expenses. This NOL is used against other items of income during the current tax year. If there is no other income to offset, the NOL would typically carryforward to the next tax year.
Congress recently changed the NOL carryback rules. Now, NOLs for 2018-2020 can be carried back five years. Congress also eliminated the 80% NOL limitation for these years. In addition, Congress removed the $500K excess business loss limitation. These changes make NOLs freely available to carryback to prior years. This presents a number of opportunities.
For 2018 NOLs. Taxpayers would have carried these losses forward and/or limited the amount used in 2018 (due to the 80% limitation or the excess business loss limitation). Amended returns may need to be filed to carry these losses back and/or to adjust the 2018 NOLs used. This will generate tax refunds.
For 2019 NOLs. Taxpayers would also have carried these losses forward and/or limited the amount used in 2019 (due to the 80% limitation or the excess business loss limitation). Amended returns may need to be filed to carry these losses back and/or to adjust the 2019 NOLs used. This will generate tax refunds.
It may be advisable to file NOL carryback on a Form 1045, Application for Tentative Refund, rather than an amended return, as the IRS is to issue refunds within 90 days of the filing of the Form 1045. This form has to be filed within one year of the close of the 2019 tax year.
For 2020 NOLs. These NOLs should be carried back. For calendar year taxpayers, the Form 1045 may need to be filed in January of 2021.
It should be noted that these carrybacks may increase the amount of tax due in the prior years. This happens as the NOL carryback reduces income and some tax deductions and credits are limited by or computed based on income. For example, charitable deductions are limited based on income. This may trigger a charitable deduction loss carryforward.
Paycheck Protection Loans
Congress changed the 7(a) loans. These loans are for businesses with less than 500 employees (generally measured by the headcount at each location separately). The eligible businesses include sole-proprietors, independent contractors, and other self-employed individuals.
The maximum loan is $10 million. But the amount is computed based on the business’ payroll expenses. Since most businesses are not going to get the full $10 million, here is the language for computing the loan amount:
1) the product obtained by multiplying—
(A) the average total monthly payments by the applicant for payroll, mortgage payments, rent payments, and payments on any other debt obligations incurred during the 1 year period before the date on which the loan is made, except that, in the case of an applicant that is seasonal employer, as determined by the Administrator, the average total monthly payments for payroll shall be for the period beginning March 1, 2019 and ending June 30, 2019; by
There are other pro-borrower features of these loans. For example, borrower and lender fees for these loans are waived. The interest rate is 4 percent. Payments are waived for six to twelve months.
To qualify, for these loans the business has to be operational on March 1, 2020 and if it had employees for whom it paid salaries and payroll taxes. For contractors, the borrower has to have been a paid independent contractor on March 1, 2020.
Those with EIDL loans (described below) cannot take out a Paycheck Protection Loan for the same purpose; however, the EIDL loans can be refinanced into the Paycheck Protection Loan.
The Paycheck Protection Loan is to be used to pay:
- payroll support, including paid sick, medical, or family leave, and costs related to the continuation of group health care benefits during those periods of leave;
- employee salaries;
- mortgage payments;
- rent (including rent under a lease agreement);
- utilities; and
- any other debt obligations that were incurred before the covered period.
Note that these expenses must be incurred during the covered loan period. The covered loan period is from March 1, 2020 through December 31, 2020.
These loans are to be administered by SBA-eligible banks. The banks are to presume that the business was impacted by Covid-19. The banks will require the borrower to make a good faith certification that the loan is necessary due to the uncertainty of current economic conditions caused by COVID-19 and that they will use the funds to retain workers and maintain payroll, lease, and utility payments. The certification also has to confirm that there isn’t another 7(a) application pending. A personal guarantee is not required for these loans.
The loan balances can be forgiven. The amount that will be forgiven equals the amount spent by the business during an 8-week period after the origination date of the loan on payroll costs (not including wages paid to an individual in excess of $100K), interest payment on any mortgage (in force prior to February 15, 2020), payment of rent on any lease (in force prior to February 15, 2020), and payment on any utility (for which service began before February 15, 2020).
The amount forgiven is to be reduced by the reduction in employees or salary. If businesses did reduce employees or salary, they have to bring them back to the February 15, 2020 level by June 30, 2020 to avoid a reduction in the amount of the loan that is forgiven.
Importantly, the forgiven loan is not counted as cancellation of debt income for the business.
Economic Injury Disaster Loans
As tax attorneys in Houston, we are familiar with Economic Injury Disaster Loans (EIDLs). Many Houston businesses took out these loans after Hurricane Harvey storms. These loans have been around for some time. They are available to small businesses and cover economic injury resulting from the disaster (such as loss of revenue).
Congress changed EIDLs to allow individuals operating as a sole proprietors and independent contractors to qualify if they are in business during the covered period (January 31, 2020 to December 31, 2020).
The qualification for EIDLs is limited to the business’ credit score, rather than the more onerous ability to repay analysis that is typically considered.
For businesses that were in business for the prior year, they can borrow up to $200,000 without the business owner having to provide a personal guarantee. There are several loan options available by the SBA, each has a maximum amount that can be borrowed (you can find these listed on the SBA website).
The borrower can request an immediate $10K advance on the loan, which has to be paid within three days. The advance can be used for providing paid sick leave to employees, maintaining payroll, meeting increased costs to obtain materials, making rent or mortgage payments, and repaying obligations that cannot be met due to revenue losses. The advance does not have to be repaid, even if the loan is not approved.
The advance is to be considered in forgiving a Paycheck Protection Loan. It is expected that many of these loans will be refinanced in to Paycheck Protection Loans that are forgivable.
Unlike Paycheck Protection Loans, these loans are administered by the SBA. Businesses apply for them on the SBA website. It is expected that the SBA will take longer than a month before making contact with applicants after the date the application is submitted. The SBA has already updated its website to request the $10K advance.
Most businesses should apply for an EIDL and request an advance. They should then seek to convert these to Paycheck Protection Loans that can be forgiven.
Section 139 Payments
Sec. 139 can also provide some relief. This Code section is not new. It provides businesses with a tax deduction for making certain Disaster Relief Payments. These are generally payments by a business to the business owner, an employee, or another party. This allows businesses to get money to individuals immediately.
These payments are deductible by the business, and not subject to income tax or employment tax (or self-employment tax) for the recipient.
To qualify, the payment has to be:
- to reimburse or pay reasonable and necessary personal, family, living, or funeral expenses incurred as a result of a qualified disaster
- to reimburse or pay reasonable and necessary expenses incurred for the repair or rehabilitation of a personal residence or repair or replacement of its contents to the extent that the need for such repair, rehabilitation, or replacement is attributable to a qualified disaster.
It appears that the President’s actions declaring the Covid-19 situation an emergency will allow taxpayers to qualify to make these payments.
To be deductible, the expense cannot be compensated by insurance or another payment.
Business owners that have cash available should consider paying expenses incurred by individuals related to the business that are will not be compensated by insurance or other payments.
For example, the owner of a small business may find that they are not able to pay their personal expenses given the downturn caused by the Covid-19 quarantine period. The business owner will not qualify for unemployment for several weeks (and it is not expected that these amounts will be included in computing any grant or loan forgiveness). The key employees for the business may be facing the same situation. The business may make payments to these individuals to cover these personal expenses.
This deduction can add to a net operating loss, which was addressed earlier in this article.
While not technically required, we typically advise the business to obtain an affidavit from the recipient confirming that the requirements of the Code have been met.
Retirement Distributions & Loans
Retirement account distributions and loans may be necessary if other funds are not available.
Congress enacted similar rules for retirement account distributions as those enacted for Hurricane Harvey. These rules allow early distributions without incurring the additional 10 percent penalty. They also allow the taxpayer to recognize the income over a three year period and to put the money back into the retirement account tax free in that time.
For some business owners, it may make sense to make a tax deductible contribution for a SEP IRA in 2020 prior to the filing deadline for 2019. This is particularly true for those who have a long term investment time horizon, who may be able to benefit from the upside gains on depressed stocks, bonds, etc. The contributions are tax deductible, which could factor into the need analysis for loans and other tax benefits related to Covid-19.
Congress also authorized employers to amend plans to allow up to $100K in loans. Loans may be preferred to taking distributions, as they are not currently taxable to the recipient.
We are here to assist clients in navigating these rules. While there are some uncertainties still, there are actionable steps that our business clients need to consider and to take sooner rather than later.
As you can see from this article, it is imperative that you keep up-to-date financial records during this time. It is also important to file original and, in some cases, amended tax returns.
Please reach out with any specific questions, or assistance with implementation in these areas.
Engineered Tax Services (561) 253-6640